The UK’s vote to leave the EU has resulted in a significant pullback in markets but investors should not over react to today’s volatility. Non-domestically focused equities may prove the best way to navigate the market uncertainty.

24/06/2016

Rory Bateman

Head of UK & European Equities

The UK’s vote to leave the EU has resulted in a significant pullback in markets but investors should not over react to today’s volatility. Non-domestically focused equities may prove the best way to navigate the market uncertainty.

There are so many issues and permutations to be considered in the event of today’s Brexit vote, it’s impossible to list them all here. We have decided on ten key points that UK and European investors should consider on this historic day.

1. Will Remain voters shun risk assets?

Many investors in the Remain camp will have taken the view that the economic uncertainties are too great to consider voting for Brexit. The UK has chosen to leave the EU, therefore many Remain voters may well decide that the risks to the economy are too great and may subsequently decide to liquidate their equity positions.

The extent of this response will determine the market reaction in the following days and weeks but there is a real danger that the negative sentiment could feed on itself to create a substantial market correction. Having said that, equities have been weak this year in the run up to the referendum so some of the negativity is already ‘priced-in’.

2. The UK stockmarket fall is a de-rating not a fundamental earnings decline

Given that over 78% of FTSE 100 revenues are derived overseas, as well as the incremental effect from weaker sterling, it seems unlikely that there will be a significant earnings hit, despite the expectations that the UK economy will suffer post the Brexit result.

We have seen the UK mid-cap FTSE 250 underperform the FTSE 100 by around 3% so far this year, so mid-cap domestically-focused businesses are already partially factoring in the anticipated weaker UK economy.

Today’s result is likely to continue that trend but long term investors should be responsive to excessive price moves driven by poor liquidity.

3. Value opportunities could emerge and firms with global exposure may outperform

European equities are now trading at all time lows relative to the US, both in local and US dollar (USD) terms. The vast majority of Europe’s underperformance versus the US since the Global Financial Crisis is due to the significant earnings differential between US and European corporates. However the recent substantial underperformance is very much related to concerns about the EU.

At some point there will be a compelling value opportunity for European equities, induced by the market rapidly pricing in a worst case scenario driven by Brexit. Quite often in times of market stress correlations are very high with indiscriminate selling and should this happen, global companies with exposures outside of Europe may well provide the most upside potential.

4. Contagion to other equity markets is possible, especially to Europe’s periphery

The UK is the second largest EU economy, accounting for 16% of GDP, so the withdrawal will be very significant for the remaining countries. Subject to the political and monetary policy response, many investors will question the sustainability of the remaining EU structure. Peripheral countries may experience a widening of their credit spreads as the market fears more EU fragmentation.

The Brexit result may well result in a stronger USD given its safe haven status funded by the weaker sterling and euro. In turn, this may feed through to lower commodity prices and negate the need for further Fed action, given the tightening effect of an appreciating USD.

As an aside, mining and resources are large constituents in the FTSE 100 which may place incremental downward pressure on the UK benchmark.

6. David Cameron to step down

Having lost the vote, Prime Minister David Cameron has announced he will step down as leader of the Conservative Party in October. Any turmoil from within his party could create additional political instability and possibly contribute to an increased UK equity risk premium and therefore further de-rating.

Markets continue to function perfectly well during periods of political turmoil but lack of unity and a leadership challenge would create market uncertainty as we have seen in Spain for example over recent months.

7. Will the EU countenance a free trade deal without free movement of people?

Whilst there genuinely appears to be no Brussels ‘Plan B’ for the Brexit outcome, we may well receive rapid notification from the EU authorities that a Free Trade Arrangement is unacceptable without free movement of people.

However, the UK is unlikely to accept free movement of people given that immigration has been the central tenet of the Brexit campaign. On the manufacturing side therefore we may well adopt World Trade Organisation (WTO) tariff arrangements which will at least be quantifiable across different sectors, e.g. 10% for the car industry etc. Where possible the market will quickly ‘price-in’ the consequences of the tariff change.

8. Service sector under pressure if Brexit implies leaving the EU single market

There will be pressure from businesses throughout Europe to negotiate a deal that allows trade to continue between the UK and Europe without major disruption given the importance for both sides, the sticking point being the movement of people problem.

Questions for the financial services industry around ‘passporting’ services to Europe from the UK will be monumental if we leave the single market given that in 2014 the UK ran a trade surplus of almost £20 billion in financial services and insurance. One assumption may be that many companies could choose to relocate parts of their business from the UK to Europe rather than risk market share loss in anticipation of a trade deal being struck.

9. The period of uncertainty could be shortened if the UK invokes Article 50

Invoking Article 50 of the EU Lisbon Treaty simply means the UK has two years before leaving the EU. It doesn’t mean trade negotiations will be agreed within the two-year period. There are 27 other countries in the EU: on some occasions a majority can pass changes in legislation, on other issues unanimous agreement is required - such as an extension of the two-year period itself.

It would seem remarkable given previous trade negotiations that the majority of legislation can be changed with such a short time frame and WTO standard trade agreements would therefore apply after the two-year period.

This has simply never been done before so market uncertainty and the higher equity risk premium may apply for a number of years. To add to the confusion, it is worth noting that the UK has had little experience in trade negotiations over many decades given the EU has conducted those discussions on the UK’s behalf.

10. Big overseas earners should benefit from the improved competitiveness of sterling

For the UK specifically, at the sector level the big overseas earners should benefit from the improved competitiveness of sterling.

From a sector perspective many of the internationally exposed industries should benefit from sterling weakness. These include consumer staples, pharmaceuticals, capital goods, resources, software etc.

Topics:

Related content

The UK’s vote to leave the EU has resulted in a significant pullback in markets but investors should not over react to today’s volatility. Non-domestically focused equities may prove the best way to navigate the market uncertainty.

Schroder Investment Management (Switzerland) AG (herein after called "SIMSAG") webpages are aimed exclusively at qualified investors with their registered office or residence in Switzerland. The SIMSAG webpage also contains information about collective investment schemes which are not approved for distribution to non-qualified investors in Switzerland.

Target group for fund distribution

Target group for fund distribution

Schroder Investment Management (Switzerland) AG (herein after called "SIMSAG") webpages are aimed exclusively at qualified investors with their registered office or residence in Switzerland. The SIMSAG webpage also contains information about collective investment schemes which are not approved for distribution to non-qualified investors in Switzerland.

QUALIFIED INVESTORS WITH REGISTERED OFFICE OR RESIDENCE OUTSIDE OF SWITZERLAND MUST NOT ACCESS SIMSAG WEBPAGES AND/OR USE THE INFORMATION CONTAINED THEREIN AS THIS MAY DEPEND UPON A DISTRIBUTION LICENSE OF THE CORRESPONDING COUNTRY. INVESTORS DOMICILED OUTSIDE SWITZERLAND ARE REFERRED TO WWW.SCHRODERS.COM.

IN PARTICULAR, INFORMATION REGARDING THE FUNDS IS NOT INTENDED FOR PERSONS IN THE USA OR PERSONS WITH US NATIONALITY OUTSIDE THE USA.

Information and no subscription solicitationDetails of the funds on SIMSAG webpages solely serve to provide information about the products. They do not constitute solicitation for subscription to shares in a fund. You should only subscribe to shares in a fund after reading the fund agreement and/or the latest prospectus, the latest audited annual report and if need be the subsequent unaudited semi-annual report as well as additional relevant documentation according to local laws. The fund agreement, the prospectus and the simplified prospectus (if applicable) as well as the annual and semi-annual report can be obtained, free of charge, from the fund management company Schroder Investment Management (Switzerland) AG, Central 2, CH-8001 Zurich. Schroder Investment Management (Switzerland) AG also acts as the Swiss representative for foreign funds. The paying agent for the foreign funds is Schroder & Co. Bank AG.

The funds are not suitable for all investors. We therefore recommend that you contact an independent financial advisor in order to determine whether investment in shares in a particular fund corresponds to your specific requirements and preferred level of risk.

Information on SIMSAG webpages do not constitute financial, legal or tax advice. You must contact a specialist for this type of information. In particular, we recommend that you consult a tax consultant for information about applicable tax laws.

No guarantee and no liabilityNo guarantee or assurance is given regarding the actuality, accuracy or completeness of fund information. This is the case even though all information on SIMSAG webpages are based on sources which we consider to be reliable and have selected carefully.

All expressions of opinion, valuations or prognoses, in particular in relation to future events or the future performance of a managed fund, originate from the corresponding author and are based on the interpretation of information available at the time. They do not necessarily correspond with the opinion of SIMSAG.

Information on SIMSAG webpages may be changed at any time without notification. Date-marked information is exclusively published for the corresponding date. There is no obligation on our part to update this information.

SCHRODER INVESTMENT MANAGEMENT (SWITZERLAND) AG, INCLUSIVE OF ITS ADVISORY BOARDS, REPRESENTATIVES, EMPLOYEES, CONTRACTORS AND CONTRACTUAL PARTNERS IS EXEMPT, TO THE MAXIMUM EXTENT POSSIBLE, FROM ANY LIABILITY FOR LOSSES OR DAMAGES WHICH ARE DIRECTLY OR INDIRECTLY CONNECTED WITH INFORMATION REGARDING FUNDS NOT BEING CURRENT, CORRECT OR COMPLETE OR WITH ACCESS TO SIMSAG WEBPAGES BEING TEMPORARILY INTERRUPTED. FURTHERMORE, LIABILITY IS EXCLUDED TO THE MAXIMUM EXTENT POSSIBLE FOR THE FOLLOWING DAMAGES: LOSS OF PROFIT; DAMAGES AS A RESULT OF A BUSINESS INTERRUPTION; FUTILE EXPENDITURE OF TIME; INDIRECT DAMAGES AND/OR CONSEQUENTIAL DAMAGES, EVEN IN THE CASE THAT THE POSSIBILITY OF DAMAGE WAS POINTED OUT OR FORESEEABLE.

Investment risksInvestors must appreciate that, as with all funds, the funds on SIMSAG webpages entail risks, including a possible loss of the invested capital. Past performance or potential profits cannot be taken as a guide to future performance or potential profits. Good past performance may not be repeated in the future. The performance indicated does not take into account commissions and costs. The price of shares in a fund and the income from them may fluctuate. Consequently, upon redemption, the shares belonging to an investor may be worth more or less than the original cost price. Please read the risk information in the fund agreement, prospectus or simplified prospectus (if applicable) for each fund. These documents can be obtained, free of charge, from Schroder Investment Management (Switzerland) AG, Central 2, CH-8001 Zurich.

ConfirmationBy clicking on "I agree", you are confirming that you have read and understood this disclaimer as well as that you are a qualified investor as defined in Article 10 para. 3 lit. c, d, and 3bis of the Collective Investment Schemes Act, CISA, having its registered office or residence in Switzerland and that you are therefore entitled to gain access to the fund information on SIMSAG webpages. Clicking on "I disagree" will automatically disconnect you from the SIMSAG webpage.